Jack Bogle: How to Tell if the Stock Market is Overvalued (Rare Interview)

That if you go back to 1949 and read Benjamin Graham's "The Intelligent Investor," he said never less than 25 or more than 75 percent in either of the two asset classes, bonds and stocks. So you can be 25% stocks and 75% bonds and work 75% stocks and 25% bonds and stay in that range. You want to make a few little adjustments? Do that. But don't think there's a scientific way to do it.

Tons to talk about. Let's just start maybe with a kind of a synopsis of the last 10 years. What are the lessons we've learned and where are we right now in the post-financial crisis world? Well, this is a great time to ask that question because it seems pretty clear to those of us who are expert who may know nothing. Never forget that.

Um, that we're going into an era of much lower returns than we've been accustomed to in the past and how that will play out nobody knows. I would be in the camp of saying the market is significantly, not grossly, but significantly overvalued. Assuming that's correct, there are only two things that can happen: you can have a long period of very low returns or a great big drop in the market, 30, 40, even 50 percent, and then get back to the good returns of the good old days.

That's a hard way to do it, but it seems almost inevitable returns will be lower somewhat than this 35 years or so that we've had the greatest bull market in recorded history, with the S&P 500 growing at 12% a year. Which means, mathematically speaking simply enough, that if you started with the S&P 500 35, 40 years ago, you now have 60 dollars for every dollar you started with.

And, uh, so it's not genius, it's the market. And, uh, you kind of wonder how the mutual fund industry has held itself together against the onslaught of indexing. I think the answer to that is in this great bull market. If you had a 10% return, which is roughly what the average fund has given you, you've got 40 times your money instead of 60. Well, nobody's looking at the 60 and they're saying any manager that can take my dollar or make, take my ten thousand dollars and turn into forty thousand dollars is my friend forever, and he's a genius, and he's actually fallen way short of the market.

So one of the lessons is, I think, or one of the messages perhaps more importantly is, you know, the trees don't go to the sky, and I'm really quite confident about that. But confidence in this business is a dime a dozen. So, um, I'll just take a moment maybe to talk about my methodology. This methodology is so good and so popular it has never been used by anybody but me, but for 25 years I've been using the same methodology.

So it's all what actually happened after prediction. I divide the market return into its two sources: one is investment return, one is speculative return. What is investment return? Today's dividend yield plus whatever earnings growth we get in the future. Now it's averaged about five percent, could get to six percent, six or seven percent. It can't really be much higher than that. Unless you get a depression, it's not going to be much lower than two.

So there's not a lot of room to differ there. But I'm using right now for the next long-term average is about five percent earnings growth. So we take today's two percent dividend yield and my estimate, guesstimate gives us six percent investment return. The other part of it, which is the more troublesome part, is speculative return, and speculative return relates to valuations, which we can easily measure by changes in the price-earning volatile.

And the PE goes from 10 to 20; that's seven percent in a decade. I don't do anything short of a decade. If it goes from 10 to 20, that's seven percent of extra return, and we got that in the 80s and we got it again in the 90s. We're not going to get it again because PEs can go from 10 to 20 to 40, but I don't think they can go to 80, which would be required if you follow the math.

Sorry to bother you with those numbers. So I think any responsible market projector predictor should look at these three elements of return: two elements of return: investment and speculation. So if I don't accept, I expect the market return to be 12% or X. I accept here's what the dividend yield is, we all know that. Here's my estimate for earnings growth, we can't be too far different on that; three or four percentage points would be a lot.

And then here's my belief on the valuation of the market. So I believe that we will probably go PE in the market is about 25 times today. That PE is based on GAAP earnings accounting earnings and not operating earnings. Operating earnings are much higher, leaves out all the bad stuff; always a good idea if you're promoting something.

And if it goes to 18 times, say that six percent that I gave you from investment return, take off two percentage points for the drop in valuation. It would give you about a four percent return in the stock market over the next decade. Now we've been doing this in 10-year periods for 25 years. That means we have 15 actual predictions and they have a correlation of about 0.81 with the actual returns.

Some of the errors were fantastic; you couldn't imagine you could be so far off. Actually, my very first estimate was the worst one, and that, as I said, the market return would be about 11 percent in the decade of the 1990s. It followed beginning 1990, and it turned out to be 18. But by 2003, the 13-year return was 11 because the market went up, stopped at the high, and went down.

So timing is a funny part of it, but I still go with that because it's the reality of life. The question really today, the big question I think for the marketers, the market itself or market experts or investors for that matter, is: will there be a reversion to the mean of the price earnings multiple or are we in some new lofty territory, a permanently high plateau? Quoting from somebody who said that right before 1929, because Roger is going to say, "Hey, permanently." I don't believe in permanently high plateaus.

Yeah, well, so what? When do we jump off this plateau and what triggers it? Well, I would have no idea about when. I just don't know, so not really much point in guessing. I mean, it could be today and it could be not a big fall at all, but just low returns. But I think the combination is pretty much set up to have returns in the range of four percent for stocks in the next decade.

Now I'm a little embarrassed because that's what most people are saying. That's essentially what BlackRock is saying, Larry Fink; it's essentially what Vanguard is saying. And I usually, in my predictions, I don't like to company the crowd. I was always taught the crowd is always wrong. So we will see, but I think it's for an investor who's thinking ahead, it's wise to be a little conservative.

Never, never, never get out of the market. You know, if you want to reduce, you know, I'm in my—I should do this right now—this little marketing. This is a present to you. Oh yay, we have to see my, um, this is the 10th anniversary edition of my new little book, which I'm not really here to plug. There are two booksellers in the back, and just you just give them your club number, we're gonna be fine.

There are no booksellers back there, obviously, but, uh, it's where I go through the mathematics that I just described to you and a whole lot of other things about the fun business. But I fall back when you get the asset allocation, that if you go back to 1949 and read Benjamin Graham's "The Intelligent Investor," he said never less than 25 percent or more than 75 percent in either of the two asset classes, bonds and stocks.

So you can be 25% stocks and 75% bonds and/or 75% stocks and 25% bonds and stay in that range. You want to make a few little adjustments? Do that, but don't think there's a scientific way to do it. Try and accommodate yourself.